Trading Flation

Today we would like to look at the monetary phenomena of inflation and deflation from a global trade perspective. The main actors here are the US, China and the catastrophe joker.

But let us start slowly.

In the US all experts have expected inflation to come down allowing for rate cuts by the FED. These are not off the table, but inflation has been more resilient than expected and many analysts now reduce the number of interest rate cuts they predict.

The strong gold price can be interpreted as a lack of confidence in the war against inflation being a quick success. But many factors play a role here. Quantitative tightening has been executed predominantly with reverse repo operations so far, leaving liquidity at a rather high level. This will end at some point in the future and dampen inflation more adamantly. However, given the limited potential growth of mature economies, any next US government is likely to continue deficit spending, which in turn will foster higher inflation alongside with higher oil prices and shipping costs, fueled further by international conflicts. The US Dollar being the reserve currency of the world, this means the US will continue to export homegrown inflation to most other economies via a financial and trade-related transmission belt.

On the other hand, there is China with shrinking growth rates, an imploding real estate sector with unknown repercussions to the rest of the word and an aggressive flood of cheap retail products delivered to other markets, mostly in Europe. So, China via its trade profile is exporting deflation to other economies.

The Eurozone is the main playground for this financial arm wrestling. Europe needs China as a trading partner and cannot ban Chinese products, as a potential US president Donald Trump might do. And Europe is not able to decouple from US capital markets completely, the interdependencies are too strong and too much in the interest of both sides.

So which arm will be stronger? We do not know. The third actor, global catastrophes like wars, climate shocks and the like could eventually decide on who wins. The interesting news for the moment is, that for a first time the European Central Bank may be in a position to move ahead of the FED on cuts, as the deflationary effect from China could give a helping hand.

The lesson for the future is, that global factors will play an increasing role in analyzing inflation, the view on the domestic economy has become far too narrow in global market places. What does this mean for you and investors globally?

In liquid markets, volatility is likely to rise for the rest of the year and alternative products can offer a shield here. Sectors that are likely to perform better in such a market setting are energy, financials and industrials. Value stocks should be preferred, laggard markets like Japan should be weighted higher. In illiquid markets private equity and real estate have lost less attractiveness than previously thought, as they may protect against inflation and valuations have come down in some segments.

But in the end, we all have to stick to our strategic asset allocation, reflect the above scenario in our tactical moves and in risk management and pick quality investments. As always.

When analyzing the overall investment scenery though, we will have to look at inflation and deflation as something like traded goods in the future.